So far it is has been a remarkable week in the global financial markets. The ’deposit grab’ in Cyprus undoubtedly has shocked international investors and confidence in the ability of euro zone policy makers has dropped to an all-time low.
Despite of the ‘Cyprus shock’ global stock markets continue to climb higher – yes, yes we have seen a little more volatility, but the overall picture is that of a continued global stock market rally. That is surely remarkable when one takes into account the scale of the policy blunder committed by the EU in Cyprus and the likely long-lasting damage done to the confidence in EU policy makers.
I therefore think it is fair to conclude that so far Chuck Norris has beaten German Finance Minister Wolfgang Schäuble. Or said, in another way the Chuck Norris effect has been at work all week and that has clearly been a key reason why we have not (yet?) seen global-wide or even European-wide contagion from the disaster in Cyprus.
Just to remind my readers – the Chuck Norris effect of course is the effect that monetary policy not only works through expanding the money base, but also through guiding expectations.
When I early this week expressed my worries (or rather mostly my anger) over the EU’s handling of the situation in Cyprus a fixed income trader who is a colleague of mine comforted me by saying “Lars, you have now for half a year been saying that the Fed and the Bank of Japan are more or less doing the right thing so shouldn’t we expect the Fed and BoJ to offset any shock from the euro zone?” (I am paraphrasing a little – after all we were talking on a trading floor)
The message from the trader was clear. Yes, the EU is making a mess of things, but with the Bernanke-Evans rule in place and the Bank of Japan’s newfound commitment to a 2% inflation target we should expect that any shock from the euro zone to the US and Japanese economies would be ‘offset’ by the Fed and the BoJ by stepping up quantitative easing.
The logic is basically is that if an European shock pushes up US unemployment up we should expect the Fed to do even more QE and if that same shock leads to a strengthening of the yen (that mostly happens when global risk aversion increases) then the BoJ would also do more QE to try to meet its 2% inflation target. Said in another way any increase in demand for US dollar and yen is likely to be met by an increase in the supply of dollars and yen. In that sense the money base is ‘elastic’ in a similar sense as it would be under NGDP targeting. It is less perfect, but it nonetheless seems to be working – at least for now.
The fact that markets now expect the supply of dollars and yens to be at least quasi-elastic in itself means that the markets are not starting to hoard dollars and yen despite the ‘Cyprus shock’. This is the Chuck Norris effect at work – the central banks doesn’t have to do anything else that to reaffirm their commitment to their targets. This is exactly what the Federal Reserve did yesterday and what the new governor of Bank of Japan Kuroda is expected to do later today at his first press conference.
So there is no doubt – Chuck Norris won the first round against Wolfgang Schäuble and other EU policy makers. Thank god for that.